National Retail Sales Tax: What would the tax rate be?

Perhaps the most controversial aspect of the national retail sales tax has been its rate: how high would it have to be to replace all revenue from the current tax system? Determining the revenue- and budget-neutral tax rate for such a tax requires making assumptions about three things: the rates of tax evasion and tax avoidance; the extent to which deductions, exemptions, and credits would be retained in the tax base; and the impact on economic growth. Under the optimistic assumption of a very broad base, and extremely conservative assumptions about evasion and avoidance, the tax rate would have to be 44 percent (on a tax-exclusive basis, or 31 percent on a tax-inclusive basis) to replace existing federal taxes in revenue-neutral fashion over the next ten years. Other analysts have estimated even higher required rates.

A key issue in determining the required tax rate is how to define the tax rate. Suppose a good costs $100 before tax and has a $30 sales tax. The tax-exclusive tax rate would be 30 percent, since the tax is 30 percent of the pre-tax selling price. The tax-inclusive rate would be about 23 percent, which is obtained by dividing the $30 tax by the total cost to the consumer ($100 + $30). Sales tax rates are typically quoted in tax-exclusive terms, but income tax rates are typically quoted as tax-inclusive rates. For example, a household that earns $130 and pays $30 in income taxes would normally think of itself as facing roughly a 23 percent (30/130) income tax rate.

Although there is no single correct way to report the sales tax rate, it is crucial to understand which approach is being used. The tax-inclusive rate will always be lower than the tax-exclusive rate, and the difference grows as the rates rise. At a rate of 1 percent the difference is negligible, but a 50 percent tax-exclusive rate corresponds to a 33 percent tax-inclusive rate—a 17-percentage-point difference.

The total sales tax rate that households would face would likely be significantly higher than the federal rates indicated above, because existing state sales tax would be added. In addition, most or all state income taxes would probably be abolished in the absence of a federal income tax system, since the state income tax systems depend on the federal system for reporting of income and other information. Today’s state income taxes would likely be converted to sales taxes, adding considerably to the combined sales tax rate.

The President’s Advisory Panel on Tax Reform, using different but reasonable assumptions about tax evasion and the breadth of the tax base, estimated the required tax-exclusive tax rate to be in the range of 34 to 89 percent. Their highest estimate assumes that tax evasion would be moderate and that the federal tax base would equal the median state sales tax base.

Other reforms would serve to further raise the required rate. Transition relief provided to households would reduce the tax base and raise the required rate even higher. And if major consumption items such as food, housing, or health care were exempted from the base (the assumptions above do not allow for such large exemptions), the rate on the remaining goods and services would rise still higher.